The New Nontraded REITs

A controversial real-estate investment is getting a makeover—and while the critics still aren't sold, some advisers say it is worth considering for investors comfortable with the risks.

The vehicles, known as "nontraded real-estate investment trusts" because they aren't traded on exchanges, have faced increasing regulatory scrutiny after investors complained of high fees, poor disclosure, frozen redemptions and erratic valuations during the property boom.

ENLARGE

A Walgreens store in Sealy, Texas, a property owned by American Realty Capital
American Realty

In response, many companies that specialize in nontraded REITs are creating new versions with lower fee structures, more redemption opportunities and shares that re-price daily.

In the past nine months, four such REITs have been launched and five more have registered with the Securities and Exchange Commission, according to Robert A. Stanger & Co., a real-estate investment bank in Shrewsbury, N.J. The companies behind these REITs hope to raise $18.3 billion.

Industry executives say these new nontraded REITs will do a better job of giving investors a way to invest in real estate without the volatility of exchange-traded REITs, which have assets of roughly $500 billion. Like existing nontraded REITs, the new ones are offering attractive initial dividends, such as American Realty Capital's nearly 7% distribution and Cole Real Estate's 5.5% distribution.

But these new structures haven't completely silenced critics, who point out that some fees remain high and investors might still face redemption problems.

Jim Sullivan, a managing director at REIT research firm Green Street Advisors, says investors are still better off investing in a publicly traded REIT. "They are more liquid, they are more transparent and the market tells you every day what they're worth," he says.

Traded REITs, like nontraded ones, are required to pay at least 90% of their taxable income in the form of dividends. But unlike nontraded REITs, traded REITs' values are set throughout the trading day, giving investors instant transparency.

Nontraded REITs first became popular a decade ago. The pitch: Long-term investors would hold them for seven to 10 years, during which time they would collect attractive dividends. Then the REITs would sell their properties or go public, returning to investors their principal plus any gains. The trade-off was that redemptions would be limited during the lives of the REITs.

But fees were high—as much as 11% in initial sales charges. And only 19 of about 90 have returned investors' principal over the years.

More recently, the vehicles have come under fire for the quarterly valuations they reported. During the downturn, when public REITs reported sharp declines in their share prices, some brokers told investors their nontraded REIT shares had barely changed from their original price.

Critics didn't think this was possible and, as regulatory scrutiny of the products' valuation methods increased, it turned out the critics were often right. For example, one nontraded REIT that specialized in shopping centers, Retail Properties of America, told investors last fall their shares were worth $6.95 each.

Last month, when the company converted to a traded company, the shares were valued at $3.20 before a reverse stock split. Retail Properties declined to comment.

In the new crop of nontraded REITs, the fee structure has been changed. For example, in the American Realty vehicle, investors have a choice: If they buy shares from a broker, they pay a 7% upfront sales fee. If they buy from an investment adviser, they pay no upfront commission. Rather, the REIT pays an annual fee of 0.7%, which goes toward paying investment advisers.

All the new REITs value their shares daily. And redemptions will likely be easier. Some will be setting aside some of the capital they raise for this purpose. For example, Cole will allocate 10% of the first $1 billion raised for redemptions and 5% thereafter. American Realty will set aside up to 20% of the capital they raise for this purpose.

The changes show that the industry is ridding itself of "bad habits and poorly structured products," says Nicholas Schorsch, chief executive of American Realty Capital. "Sponsors who didn't adapt to change will fade away or close down."

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